Jim and Margaret Cuthbert examine the report of the Scotland Bill Committee and conclude that conflicts of interest and inadequate scrutiny means that the Committee has failed Scotland

In 2010, the Westminster coalition government introduced the Scotland Bill – a bill proposing new powers for the Scottish Parliament, set firmly in the context of the Union. The Bill incorporated most of the recommendations of the Calman Committee set up by Wendy Alexander. The major proposals in the Bill are those concerning fiscal accountability – in particular, the introduction of income tax powers. Although this is a Westminster Bill, under the terms of the Sewel convention its principles must be approved by the Scottish Parliament. This makes it crucial that the Bill is subject to detailed, independent scrutiny in Scotland. To provide this scrutiny the Scottish Parliament set up a Scotland Bill committee. The committee has now reported, with the majority endorsing the income tax proposals.

In this paper we directly challenge the findings of the committee on the income tax proposals. Scottish Left Review readers may recall that in an article last November we argued that there were serious technical flaws in the Calman income tax proposals. In this paper we will show that the committee did not adequately address these points. Secondly, we will show how our latest work in fact strengthens our original concerns. Overall, the committee has not adequately addressed the effect which the operation of the proposed tax system will have in distorting the incentive to raise taxes - in a way which will almost certainly lead to higher taxes in Scotland than would otherwise be the case.

First, however, we give some background on the procedures of the Scotland Bill Committee. The Committee had Wendy Alexander, the person who had instituted the Calman commission, as its Chair: and as its advisors, it appointed the former Secretary to the Calman commission and a member of its expert group. Without any reflection on the individuals concerned, it is difficult to see how this is compatible with the committee being seen to carry out an independent scrutiny of the Calman proposals. We accordingly declined to appear in front of the Committee. We submitted the Committee our already published papers on Calman, but made it clear that we would not give further evidence, or report on our ongoing work.

In our original paper we demonstrated two technical flaws in the Scotland Bill. Given Scotland’s poor economic performance relative to the UK and EU competitors, it is likely that Scottish governments will be interested in stimulating the economy. We hypothesised that to do so a Scottish government might use a combination of some of the considerable powers it already has, in conjunction with a reduction in the Scottish rate of income tax: and that it is possible that this could result in an increase in economic activity and an actual increase in total income tax revenues in Scotland. However, the tax revenues coming to the Scottish government would almost certainly fall in these circumstances, because under Calman, the Scottish government would get a decreasing share of the total income tax take. Conversely, an increase in the Scottish rate of tax, even if it deflated the Scottish economy, and lowered overall tax revenues, would nevertheless almost certainly increase the tax coming to the Scottish government. So a Scottish government which was short of revenue would be under considerable pressure to raise tax rates. And a Scottish government operating under Calman would indeed be under severe financial pressure: not just because of the current prospects for public expenditure, but also because of the second Calman flaw, which means that, through the effects of fiscal drag, the Scottish government would receive a decreasing proportion of the overall income tax revenue raised in Scotland.

The evidence given to the committee dealing with our specific arguments came mainly from Iain McLean, and Anton Muscatelli: the first was a member, and the second the Chair, of the Calman expert group. Iain McLean argued in his evidence, and at greater length in a Scotsman article of 11 January, that we were mistaken as regards both of the flaws that we had pointed out. We will now examine Iain McLean’s arguments in detail – and show how he, in fact, got it wrong. But first, since McLean developed his criticism of our first argument in terms of something known as the Laffer curve, we explain what this is.

The Laffer curve describes the notional relationship between tax revenues raised and the tax rate. The way the thinking goes is as follows. Suppose a government set a zero rate for income tax: then clearly it would raise no revenue. If, however, it set an income tax rate of 100 pence in the pound, then the population would not find it worthwhile to work, so again the government would raise virtually no revenue. So as the tax rate is increased, from the lower to the upper of these two extremes, and with everything else assumed unchanged, the total of tax revenues raised must first of all rise, until reaching a maximum at a particular tax rate, before declining from then on. This notional relationship, something like an inverted ‘U’, between tax rate and tax revenue is the Laffer curve – usually ascribed to the Chicago economist Arthur Laffer.

Iain McLean chose to criticise our original argument in terms of the Laffer curve, even though we did not postulate our original argument in terms of it. What he said was that, for our first claimed flaw to hold, then the country would have to be positioned beyond the highest point of the Laffer curve: that is, in the area where an increase in tax rate led to a decrease in overall revenues. But, McLean argued, available evidence indicates that the UK is placed well on the left hand side of the income tax Laffer curve, in the position where increases in tax rate yield increases in overall revenue. So, while our first claimed Calman flaw was indeed a technical possibility, it did not arise in practice.

Even in terms of the material available in our published papers, Iain McLean’s argument is wrong. What we argue is that a Scottish government might be able to stimulate the economy, and increase total income tax revenues collected in Scotland, by a combination of an income tax cut and a package of other measures, like action on utility prices and business rates. It is perfectly feasible to envisage such a combined package being successful, even if the ‘pure’ Laffer curve at that point was upward sloping. But if tax revenues increased as a result of such a package, the Scottish government itself would almost certainly receive less revenue – since it would, under the Calman rules, be receiving a decreased share of the increased tax take. So McLean was wrong to claim that our first flaw only operated to the right of the peak of the Laffer curve.

Work we have done subsequently provides more insight into the effect which the Calman proposals will have on a government’s incentive to raise tax. And since McLean has introduced the concept of the Laffer curve it is convenient to illustrate this point by using it. What we want to do is compare the position of a Scottish government operating under the Calman rules, when it sets the Scottish rate of income tax at X pence in the pound, with the position of an independent Scottish government, which we assume is facing exactly the same Laffer curve, and which starts off with an equivalent tax rate: that is, 10+X for the basic rate, and so on. (So that, as far as the Scottish taxpayer is concerned, the same overall rate of tax is being levied under the ‘Calman’ and ‘independence’ scenarios).

Now consider the question: how much extra revenue will the Scottish government operating under Calman get, if it increases the Scottish rate of tax by one pence, compared with the amount the independent Scottish government would get if it raised its tax by one pence? Our latest work demonstrates that, no matter where we are on the Laffer curve, then under all feasible scenarios the Scottish government operating under Calman would get more revenue from a one pence increase in the tax rate than an independent Scottish government would from a one pence increase in its tax rate. Moreover, the evidence suggests that the difference between the amounts of revenue raised is, in most circumstances, likely to be material. The relevant algebra is set out at www.cuthbert1.pwp.blueyonder.co.uk.

The crucially important implication is that no matter where we are on the hypothetical Laffer curve, the implementation of the Calman proposals significantly distorts the incentive to change the tax rate, compared with an independent Scottish government facing the same Laffer curve (or, for that matter, compared with a UK government facing a Laffer curve of a similar shape). It will always be more worthwhile for a government operating under Calman to increase its rate of tax: and conversely, a Scottish government operating under Calman would always suffer a greater penalty, if it lowered its rate of tax. This consistent and significant shift in the incentive to raise tax is likely to have an entirely predictable outcome in practice: namely, a Scottish government operating under Calman is likely to set a higher rate of tax than an independent or UK government facing the same shape of Laffer curve. And if we assume that the independent (or UK) government achieves a close to optimum tax rate, the implication is that the government operating under Calman is likely to set a tax rate which is too high – and which is therefore deflationary for the Scottish economy.

Now consider our second point, which relates to the effects of fiscal drag. What Iain McLean said was that fiscal drag would not be a problem, because a rational government would always re-index tax allowances and rates from time to time to keep up with inflation. Anton Muscatelli went further, and claimed that governments will ultimately adjust tax to GDP and government spending to GDP ratios to be relatively constant in the long-run. But even if the UK government did indeed ensure that the overall ratio of income tax to GDP was constant in the long term, this could still be perfectly consistent with a higher proportion of the overall tax take coming from the higher rate tax bands. And if this were to happen, then the tax take for a Scottish government operating under Calman would indeed decline relative to GDP – since under Calman the Scottish government receives a lower proportion of higher rate band tax revenues.

What this means is that McLean and Muscatelli’s arguments do not, in fact, answer our concerns about the effect of fiscal drag. Moreover, empirical evidence is now available, (which was not available when we wrote our earlier papers), which actually confirms our concerns. Surprisingly, this evidence comes from the Secretary of State for Scotland and sponsor of the Scotland Bill, Michael Moore: he produced for the Scotland Bill committee estimates of what the yield of a 10 pence Scottish rate of tax would be, for each of the years 1999/2000 to 2007/08. Unfortunately the figures were not in a very helpful form – since what he gave the committee was the estimated yield for a 10 pence Scottish rate of tax, expressed as a percentage of total income tax receipts for the UK as a whole. Perhaps he did this because, expressed in this way, the figures are relatively stable: as a percentage of UK income tax receipts, the Scottish 10 pence yield starts at 2.8 per cent in 1999/2000, rises to 3 per cent by 2003/04, and then declines to 2.8 per cent again by 2007/08 – that is, back to where it started at the beginning of the period.

If, however, the figures are re-calculated on a different basis to express the yield of a Scottish 10 pence rate as a percentage of Scottish income tax receipts, then a very different picture emerges. The relevant figures are given in the following table:

Yield of a Scottish 10 pence rate as a percentage of Scottish income tax receipts

1999/00

40.0

2000/01

40.1

2001/02

41.7

2002/03

41.7

2003/04

41.0

2004/05

40.05

2005/06

38.1

2006/07

37.8

2007/08

37.8

It is necessary to take into account any major changes in tax rates or bands which occurred during this period: (that is, apart from normal marginal adjustments to tax bands). In fact, there were two major changes: taking effect in 2000/01, there was a one pence reduction in the previous 23 pence basic rate of tax to 22 pence: and taking effect in 2001/02, there was a 23.7 per cent increase in the upper threshold for the 10 pence lowest rate of tax. Both of these changes would have had the effect of increasing the yield of a Scottish 10 pence rate as a percentage of Scottish tax receipts.

It is likely that these major changes account for the initial increases in the 10 pence yield as a percentage of Scottish receipts in the above table. But thereafter, the percentages fall consistently year by year – and end up well below the initial percentage. This is entirely consistent with the anticipated effects of fiscal drag on the yield of a Scottish 10 pence rate: and is strong evidence in support of the view that fiscal drag would put the finances of a Scottish government operating under Calman under consistent pressure. Overall, therefore, the arguments put forward against our position by McLean and Muscatelli do not stack up: and the further work we have undertaken, and Michael Moore’s figures on 10 pence tax receipts, in fact strengthen our original concerns. The consistent effect which the Calman arrangements have in increasing the incentive to raise tax, over effectively the whole range of the Laffer curve, is likely to mean that a Scottish government operating under Calman will be forced to set tax rates too high.

This should not be regarded as a surprising, or outlandish, conclusion. What we are talking about here, where a ‘federal’ government shares the same tax base with a constituent state, gives rise to the potential for what is known in the literature as ‘vertical tax competition’. There is no overall consensus on what the effects of such vertical tax competition will be: but there is certainly a strong strand in the literature which takes the view that the likely outcome will be that taxes will be set at an inefficiently high level. This is illustrated by the following excerpt from a recent paper by Chernick and Tennant, from the journal Publius, (an academic journal concerned with the theory of federalism):

“The more harmonized revenue systems are—i.e. the more the national and provincial/state level share the same tax bases—the greater the potential for competition between levels of government, and the greater the potential for overall rates of taxation to be inefficiently high.”

This clearly indicates that the sorts of effect we have identified are regarded as constituting a very active danger, and not something to be brushed away (as some members of the expert group did) as highly unlikely to happen. In terms of this quotation, the Calman arrangements could almost have been designed to maximise the danger – since what we have under Calman are tax bases which, by design, are totally aligned.

Further, a factor which will tend to inhibit states from raising taxes in a usual federal/state system will not apply under the Calman implementation. Where there are multiple states in a federation, each with the ability to set its own tax rate, these states will tend to be inhibited from raising taxes by the prospect of other states lowering their tax rates in response. This game theoretic inhibition does not apply in the Calman context, because the only subsidiary state with the ability to change its tax rate will be Scotland. This last point suggests that the Scotland Bill committee should have been much more cautious than they were about accepting the Canadian example as a guide.

The upshot is that the Scotland Bill committee report contains an altogether inadequate discussion of the nature of the distorted incentives which the Calman proposals introduce for the tax setting government: and gravely underestimates the danger of the Scottish tax rate being set at too high a level. Unfortunately, such a flawed outcome was almost inevitable, given the procedural inadequacies which were built into the arrangements for the Committee – with those with major responsibility for the Calman process being, to a large extent, judge and jury in their own case. The consequences will be borne by the Scottish people as regards the damage which will result to the economy: and in political terms, largely by the Labour Party. Unless, of course, the Scottish Parliament surprises us all, refuses to vote on purely party lines, and does not simply rubber stamp the existing flawed tax proposals before they are passed back to Westminster.

Jim and Margaret Cuthbert are independent economists and statisticians. They are not affiliated to any political party. To view their papers on economics and statistics go to www.cuthbert1.pwp.blueyonder.co.uk